Measuring the Cost of Living

N. G R E G O R Y M A N K I W

PowerPoint® Slides

by Ron Cronovich

In this chapter, look for the answers to

these questions:



What is the Consumer Price Index (CPI)?

How is it calculated? What’s it used for?



What are the problems with the CPI? How serious are they?



How does the CPI differ from the GDP deflator?



How can we use the CPI to compare dollar

amounts from different years? Why would we want to do this, anyway?

The Consumer Price Index (CPI)



Measures the typical consumer’s cost of living.



The basis of cost of living adjustments (COLAs)

How the CPI Is Calculated

1.

Fix the “basket.”

The Bureau of Labor Statistics (BLS) surveys

consumers to determine what’s in the typical

consumer’s “shopping basket.”

2.

Find the prices.

The BLS collects data on the prices of all the

goods in the basket.

3.

Compute the basket’s cost.

How the CPI Is Calculated

4.

Choose a base year and compute the index.

The CPI in any year equals

5.

Compute the inflation rate.

The percentage change in the CPI from the

preceding period.

100

x

cost of basket in current year

cost of basket in base year

CPI this year

–

CPI last year

CPI last year

inflation

EXAMPLE

_{basket: {4 pizzas, 10 lattes}}

$12 x 4 + $3 x 10 = $78

$11 x 4 + $2.5 x 10 = $69

$10 x 4 + $2 x 10 = $60

cost of basket

$3.00 $2.50 $2.00 price of latte $12 2005 $11 2004 $10 2003 price of pizza year

Compute CPI in each year:

2003: 100 x ($60/$60) = 100

2004: 100 x ($69/$60) = 115

2005: 100 x ($78/$60) = 130

15%

13%

A C T I V E L E A R N I N G

1:

Calculate the CPI

The basket contains 20 movie tickets

and 10 textbooks.

The table shows their prices for 2004-2006.

The base year is 2004.

A. How much did the basket cost in 2004?

B. What is the CPI in 2005?

C. What is the inflation rate from 2005-2006? movie

tickets

text-books

2004 $10 $50

2005 $10 $60

A C T I V E L E A R N I N G

1:

Answers

A. How much did the basket cost in 2004?

($10 x 20) + ($50 x 10) = $700

movie tickets

text-books

2004 $10 $50

2005 $10 $60

2006 $12 $60

The basket contains 20 movie tickets

A C T I V E L E A R N I N G

1:

Answers

B. What is the CPI

in 2005?

cost of basket in 2005

= ($10 x 20) + ($60 x 10) = $800

CPI in 2005 = 100 x ($800/$700) = 114.3

movie tickets

text-books

2004 $10 $50

2005 $10 $60

2006 $12 $60

The basket contains 20 movie tickets

A C T I V E L E A R N I N G

1:

Answers

C. What is the inflation rate

from 2005-2006?

cost of basket in 2006

= ($12 x 20) + ($60 x 10) = $840

CPI in 2006 = 100 x ($840/$700) = 120

Inflation rate = (120 – 114.3)/114.3 = 5%

movie tickets

text-books

2004 $10 $50

2005 $10 $60

2006 $12 $60

The basket contains 20 movie tickets

What’s in the CPI’s Basket?

42%

17% 15%

6% 6%

6%

4% 4% Housing

Transportation

Food & Beverages

Medical care

Recreation

Education and communication Apparel

Problems With the CPI:

Substitution Bias



Over time, some prices rise faster than others.



Consumers substitute toward goods that

become relatively cheaper.



The CPI misses this substitution because it uses

a fixed basket of goods.

Problems With the CPI:

Introduction of New Goods



When new goods become available,

variety increases,

allowing consumers to find products

that more closely meet their needs.



This has the effect of making each dollar more

valuable.



The CPI misses this effect because it uses a

fixed basket of goods.

Problems With the CPI:

Unmeasured Quality Change



Improvements in the quality of goods in the

basket increase the value of each dollar.



The BLS tries to account for quality changes,

but probably misses some quality improvements,

as quality is hard to measure.

Problems With the CPI



Each of these problems causes the CPI to

overstate cost of living increases.



The BLS has made technical adjustments,

but the CPI probably still overstates inflation

by about 0.5 percent per year.



This is important, because Social Security

Two Measures of Inflation

-5 0 5 10 15

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Percent per Year

Imported consumer goods:



included in CPI



excluded from GDP deflator

The basket:



CPI uses fixed basket



GDP deflator uses basket of

currently produced goods & services This matters if different prices are

Capital goods:



excluded from CPI



included in GDP deflator (if produced domestically)

A C T I V E L E A R N I N G

2:

CPI vs. GDP deflator

In each scenario, determine the effects on the

CPI and the GDP deflator.

A.

Starbucks raises the price of Frappuccinos.

B.

Caterpillar raises the price of the industrial

tractors it manufactures at its Illinois factory.

C.

Armani raises the price of the Italian jeans it

A C T I V E L E A R N I N G

2:

Answers

A.

Starbucks raises the price of Frappuccinos.

The CPI and GDP deflator both rise.

B.

Caterpillar raises the price of the industrial

tractors it manufactures at its Illinois factory.

The GDP deflator rises, the CPI does not.

C.

Armani raises the price of the Italian jeans it

sells in the U.S.

Correcting Variables for Inflation:

Comparing Dollar Figures from Different Times



Inflation makes it harder to compare dollar

amounts from different times.

EXAMPLE:

The High Price of Gasoline



Price of a gallon of regular unleaded gas: $1.42 in March 1981

$2.50 in August 2005



To compare these figures, we will use the CPI to

express the 1981 gas price in “2005 dollars,”

what gas in 1981 would have cost if the

cost of living were the same then as in 2005.



Multiply the 1981 gas price by

196.4 $2.50/gallon 8/2005 88.5 $1.42/gallon 3/1981 CPI Price of gas

date

EXAMPLE:

The High Price of Gasoline



1981 gas price in 2005 dollars = $1.42 x 196.4/88.5

= $3.15



After correcting for inflation, gas was more expensive in 1981.

A C T I V E L E A R N I N G

3:

Exercise

1980: CPI = 90,

avg starting salary for econ majors = $24,000

Today: CPI = 180,

avg starting salary for econ majors = $50,000

A C T I V E L E A R N I N G

3:

Answers

Solution

Convert 1980 salary into “today’s dollars”

$24,000 x (180/90) = $48,000.

After adjusting for inflation, salary is higher today than in 1980.

1980: CPI = 90,

avg starting salary for econ majors = $24,000

Today: CPI = 180,

Correcting Variables for Inflation:

Indexation

For example, the increase in the CPI automatically

determines

•

the COLA in many multi-year labor contracts

•

the adjustments in Social Security payments

and federal income tax brackets

A dollar amount is

indexed

for inflation

if it is automatically corrected for inflation

Correcting Variables for Inflation:

Real vs. Nominal Interest Rates

The nominal interest rate:

•

the interest rate not corrected for inflation

•

the rate of growth in the dollar value of a deposit or debt

The real interest rate:

•

corrected for inflation

•

the rate of growth in the purchasing power of a deposit or debt

Real interest rate

Real and Nominal Interest Rates:

EXAMPLE



Deposit $1,000 for one year.



Nominal interest rate is 9%.



During that year, inflation is 3.5%.



Real interest rate

= Nominal interest rate

–

Inflation

= 9.0%

–

3.5% =

5.5%

Real and Nominal Interest Rates in the U.S.

-10 -5 0 5 10 15

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

In te re s t R a te s (p e rc e n t p e r y e a r)

CHAPTER SUMMARY



The Consumer Price Index is a measure of the cost of living. The CPI tracks the cost of the

typical consumer’s “basket” of goods & services.



The CPI is used to make Cost of Living

Adjustments, and to correct economic variables for the effects of inflation.